Intentional Conduct May Be Required to Prove Defalcation under Section 523(a)(4) In Certain Circuits

(Excerpt) In the average bankruptcy case, individual debtors seek to discharge some, all, or most of their debts. The Bankruptcy Code (the “Code”) sets certain limits on the dischargeability of obligations. For example, section 523 of the Code provides circumstances in which certain debts are not dischargeable. Specifically, section 523(a)(4) provides that an individual debtor will not be discharged from any debt “for fraud or defalcation while acting in a fiduciary capacity.” In the bankruptcy context, defalcation means “the failure to meet an obligation.” However, the Code is silent as to the level of culpability required to prove defalcation. The circuit courts have established varying standards to prove defalcation under the Code, ranging from intentional conduct to an innocent mistake as sufficient to prove defalcation, rendering the debt nondischargeable. Part I of this memorandum generally discusses defalcation. Part II discusses and compares the various standards adopted by the circuits as to the level of culpability required to prove defalcation. Part III discusses the various policy goals of discharge and how it relates to section 523(a)(4). The memorandum concludes that courts should follow a standard similar to that laid out in In re Mueller, a standard requiring a plaintiff show a defendant committed a willful, knowing, or reckless breach of a fiduciary duty. This standard allows an “honest but unfortunate debtor” to emerge from bankruptcy with a fresh start, a goal achieved through the discharge